Overlooking Water When Buying Land
BY: Deborah Stephenson, DMS Natural Resources LLC
Benjamin Franklin’s statement, “When the well’s dry, we know the worth of water” speaks to the importance of water. However, water is an often overlooked asset in the land purchasing and decision making processes. In most states, when properties change ownership, water rights are automatically conveyed unless specifically reserved in the deed. As a result, it is typical for landowners to be unaware or unfocused on the water rights appurtenant to their property. Property owners should focus on the water entitlements they will own when buying land, and their potential uses and the value of the water under each use. Armed with this information, landowners can make decisions weighing the costs and benefits of utilizing their water in various manners.
Landowners can sometimes be surprised to find that the value of water can be higher if transferred off the property. And, astonishingly, in select circumstances, the value of the water can exceed the value of the appurtenant land. The value of water can be evaluated in two ways: its appraised market value or its contribution to returns under various operational practices.
APPRAISED VALUE OF WATER
Similar to a land appraisal, water rights can be appraised when in the process of buying land. Water right appraisals consider water as a distinct asset and will result in the current fair market value. This information can be useful in many situations including, but not limited to, support for government funding for water right purchase and leases; information for debt holders and determination of damages imposed in lawsuits. In a traditional water right appraisal, there are seven key attributes that influence value:
- Quantity – The quantity of water that a water right yields.
- Marketable Region – The feasible region in which the asset can be transferred to a new user.
- Alternative Water Supply Options – Availability of existing water supplies and future water development opportunities within the region.
- Water Quality – The quality of a water source can influence the suitability of a water right for a potential new use.
- Reliability – The amount of water that is regularly available to the water right holder compared to the claimed or stated volume on the water right. The amount of water available is determined based on a combination of water source yields, hydrological conditions, and the water right’s legal attributes – mainly priority date.
- Seasonality – The period during which the water right holder can divert or withdraw water from the source.
- Highest and Best Use – The highest value use to which the water right can physically and legally be put to use.
VALUING WATER TO MAKE OPERATIONAL DECISIONS
While arriving at the appraised value of a water right can be useful in many situations, it can be somewhat academic and oftentimes does not help with making on the ground decisions. Landowners need tools to understand the value of their water assets in relationship to operational
decision making. Evaluating a water right in the context of operational decision making is typically based on three considerations:
- Utilizing the water in the current agricultural operation.
- Utilizing the water on-site, but changing the use to a non-agricultural purpose.
- Decoupling the water and transferring it off the property.
Agricultural Operation: Water typically increases the return from an agricultural operation. Water increases crop yields, allows for development of a wider range of crops, and quenches the thirst of livestock. These benefits, although well understood by landowners, are not simple to translate into a value of the water itself. The overall net income of an agricultural operation is dependent upon several factors including hours of labor, efficiency, and design. It can be difficult to decouple the impacts from other factors to isolate the value of the water to the operation. The landowner must evaluate not only the benefits provided from the water, but also the incremental costs associated with utilizing the water. Typical costs include ditch or canal company dues, energy costs due to running pivots or pumps, and labor costs to employ irrigation practices. There is an economic valuation methodology available called the Income Capitalization Approach that takes into account all of the cost and benefit factors thereby isolating the value of water to an agricultural operation. In certain circumstances, the costs of utilizing water in the agricultural operation may actually outweigh the incremental increase in revenue. Presented with this situation, a landowner can choose to stop using the water (which in most states will subject his water rights to abandonment or forfeiture through non-use), try to sell or lease the water off the property, or maintain the use of the water in the current operation and incur a net loss. Although the last option does not sound appealing, incurring a loss in today’s operation can be viewed as an investment to maintain the water asset, preventing abandonment or forfeiture. In addition to the benefit of preserving the water rights, the short term losses must also be compared to the potential future revenue opportunities.
The future revenue from the agricultural operation may increase due to higher commodity prices or the property may be located in an area with growing urban and industrial water demand. These demands will place pressure on the external market price for water, driving future sale/lease opportunities. If the future potential revenue opportunities outweigh the short term losses, it may be worthwhile to maintain the use of your water rights even though it might not be currently profitable.
On-Site, But Alternative Purpose of Use: Another option that may be available to landowners is to utilize the water rights on-site, but change the purpose of use. In this scenario, the landowner could change the use of their water rights to support the development of a wetland. In some areas, this may increase property values or enable the land owner to sell mitigation credits. Another scenario may be that the landowner changes the use of the water rights to instream flow to enhance the fisheries. This may result in an increase in property value, or enable the water rights to remain active over a period of time when agricultural use is not anticipated.
The decision to change a water right’s purpose of use will include an analysis of the forgone net agricultural income, the costs associated with a water right change application with the regulatory authorities, and the costs to develop the new use of the water. The costs would be compared to the potential benefits which may include increased property value and/or sale of wetland mitigation credits.
Off-Site: A third opportunity that may be available to some water right holders is to decouple the water right from the appurtenant land and transfer it to another user, location or possibly even for another purpose. In most western states water rights can be severed from the appurtenant property and transferred to another entity. A water right’s place of use, point of diversion, and/or purpose of use may also be changed. Certain regions with growing municipal and industrial users have demand for additional water supplies. In other areas environmental organizations may be interested in leasing water to keep instream for the benefit of the fisheries. If property is located in an area in which there is external demand for water, there may be an opportunity to sell or lease water rights. As is the case with changing the purpose of use on site, the land owner would have to examine the costs including the forgone net agricultural income, the expense associated with a water right change application with the regulatory authorities, and any additional transaction costs. This analysis should also take into account the future plans for the property. A water right owner may not want to sever and sell water from the property if they plan to develop the site in the future for residential use. Although possible revenue may be obtained today, the landowner may pay more in the future to obtain water for the residential development.
Weighing the Alternatives: Many respected experts have long preached that major conflicts will arise around water shortages. This issue is already a fact of life in heavily populated desert environments in the western United States and other parts of the world. In the northern Rockies we tend to take water rights for granted to some extent, while in Colorado, Nevada, Arizona, and New Mexico entire ranches have been bought solely for their water rights. Residents in the desert regions of the western United States already know how important and valuable their water rights are. Comparatively, in other areas, land owners are just starting to understand water rights and their value.
Do not overlook water when buying land. It is an important asset to take into consideration at both the land buying stage and decision making stage.
Considering buying land? Check out Hall and Hall today.
■ Deborah Stephenson founded DMS Natural Resources LLC (DMS) in 2011. DMS is an advisory firm specializing in the water and agricultural sectors